India’s Widening Fiscal Deficit– Background

India is at an important juncture in its fiscal consolidation path. Multiple factors such as a spike in oil prices, increased expenditure on account of farm loan waivers, and insufficient revenues have brought the 3.3% target set by the government under question. Before we proceed to analyse the fiscal deficit, the budget and the ways to achieve the target, it is important to have an understanding of where this 3% target comes from.

Given the poor state of fiscal affairs at the central and state levels at that time, the then Finance Minister Mr. Yashwant Sinha introduced the Fiscal Responsibility and Budget Management Bill to the parliament in 2000. With state and the central government facing challenges having run even a revenue deficit, it was of paramount importance that the fiscal position of the states and central government be improved. To that effect, it was necessary to institutionalize fiscal discipline by way of an act of parliament. The Fiscal Responsibility and Budget Management (FRBM) Act was enacted in 2003 setting stringent targets for the states and the centre. It called for the elimination of revenue deficits, a situation where the revenue isn’t enough to meet the expenses of maintaining the government. The reduction in the fiscal deficit, the difference between expenditure and revenue without borrowings, and a reduction in debt levels. The states and centre’s fiscal deficits were pegged at 3% (barring a few exceptions at the state level).

In order to attain these goals, three accompanying documents were introduced to be presented with the budget – the Medium-term Fiscal Policy Statement, the Fiscal Policy Strategy Statement and the Macroeconomic Framework Statement. These documents help layout how revenue, expenses and debt will be managed in the present year as well as the coming years. Over the past 15 years, the FRBM has played an important role in streamlining state and central finances. For instance, following the adoption of the FRBM, state governments didn’t use up their higher revenues to increase populist spending in years leading up to 2008, when the limits were temporarily suspended in accordance with the emergency provisions in the act.

While the central and state governments have come a long way in terms of consolidating and streamlining their finances, another pivot was recommended by the N.K. Singh committee in 2017. The finance minister set the FY19 fiscal deficit target at 3.3% and said that India ‘might’ achieve its 3% fiscal deficit target in FY20. These figures are farther from the N.K. Singh committee recommendations of 3% of GDP up to FY20 followed by a cut to 2.8% in FY21 and finally stabilizing at 2.5% FY23. However, in the present scenario, a fiscal deficit of 3.5% seems more likely. Having understood the background, it is important to understand the implications of a wide fiscal deficit.

As has been gathered, fiscal deficits arise due to the government spending more than its receipts for the year. During ‘normal’ periods, fiscal deficits can crowd out private borrowing, distort capital structures and manipulate interest rates. These result in changes in the economy in terms of decrease net exports or higher taxes to increase government revenue. The higher spending by the government also has inflationary pressures in the economy, pushing inflation upwards. However, during times of crisis, increased fiscal spending help bring about a recovery in the economy. Increased spending played an important role in 1929 as well as during the 2008 crisis. Fiscal deficits can bring about growth.

The relationship between fiscal deficits and trade deficits have also been examined by certain researchers finding a positive relationship between the two. Two scholars Anoruo and Ramchander in 1998 established that rising current account and fiscal deficits impact the long-term viability of economic progress of a nation. With increasing budgetary deficits driving trade deficits, the trade deficit cannot be altered until the fiscal deficit is corrected. Crowding out is when an increase in government spending results in a decrease in private investment and consumption. There are two theoretical variants of crowding out – financial and real. Real crowding out displaces private capital formation while financial crowding out is a partial loss of private capital formation as interest rates rise resulting in “Pre-emption of real and financial resources by the government through bond-financing of the fiscal deficit”.

Keeping all this in mind is essential to be able to analyse India’s situation in particular.

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